Understanding S&P 500 Earnings Estimates

Q4 2015 earnings are almost finished being reported and they were fairly disappointing overall. Revenues were down 4.5% and earnings down 8.4% (on non-GAAP numbers). Once again, we watched sell side analysts have to revise their earnings estimates after being overly optimistic. But how optimistic are they about future earnings? I’ll answer that and explain why I have a problem with their earnings estimates.

Generally Accepted Accounting Principles (GAAP)

Generally accepted accounting principles (GAAP) are a set of principles that U.S. companies must use to compile their financial statements. The Financial Accounting Standards Board (FASB) issues a codification of accounting standards that companies are required to follow. These standards are meant to ensure that financial statements are consistent and comparable for investors. Most companies have found that there are certain accounting standards that negatively impact their company’s “true earnings power.” These companies will disclose a non-GAAP earnings per share in their financial statements in an attempt to show investors what they believe are the real earnings of the business. These non-GAAP earnings are sometimes helpful if there are one time items that impact earnings. However, many companies will disregard fundamental accounting like revenue recognition standards in their non-GAAP earnings. They will paint the rosiest picture they possibly can for current and prospective investors. I will give a few examples of some offenders.

Sell Side Analyst S&P 500 Estimates

When sell side analysts estimate S&P 500 earnings, which do you think they use? You guessed it, they use non-GAAP earnings. This isn’t a big problem if the variance between GAAP and non-GAAP earnings is small. However, currently the difference between the two is wide. Really wide. 2015 GAAP earnings per share (EPS) was $91.46 vs. non-GAAP of $117.92. This is the largest variance since 2008. See chart below:

Many people believe the market is trading at a P/E ratio of about 17. The only problem is, the earnings used in this calculation are non-GAAP or “fantasy earnings.” In reality, the market is trading at a P/E ratio north of 22x on a GAAP basis. The mean P/E over the last 100 years on the S&P 500 is 15.1x using GAAP EPS. It is important to note that these ratios are not predictive of short term market moves. They are more predictive of long-term future market returns.

Non-GAAP Earnings

Non-GAAP earnings serve a great purpose to investors when used properly. Today, this metric is widely overused with 88% companies in the S&P 500 disclosing it. Even more worrisome is that 82% of the time the adjustments increase net income. This metric is seen as a way for some companies to juice up their numbers. Lets take a look at Tesla (NASDAQ:TSLA). They have decided to disregard revenue recognition standards in their non-GAAP earnings. They enjoy recognizing all of the fees from the life of a car lease up front instead of the amount the customer has actually paid. They also like to play with the expense side of the income statement by not accounting for stock based compensation. These are the two large adjustments they make. However, it looks like there are five more that are smaller. The Q4 2015 GAAP net loss shrinks from $320 million to $114 million on a non-GAAP basis. During the Q4 2015 earnings presentation they announced they believe they can post a profit in Q1 using non-GAAP numbers.

One of the worse offenders is LinkedIn (NYSE:LNKD). LinkedIn also does not account for stock based compensation in non-GAAP earnings. Additionally, they choose to not amortize the intangible assets they have previously acquired. These two adjustments swung their GAAP net loss of $8 million to a non-GAAP profit of $126 million. This company has been doing this ever since they IPO’d. They have never consistently made money. It is anyone’s guess if they ever will. I have my doubts. However, they will continue to muddy up the waters for investors as long as they can.

Even as the overall market has rebounded 11% in the last four weeks, earnings estimates have continued to drop. As of today, Q1 2016 earnings are expected to be down 8.3% YoY. However, full year 2016 earnings estimates remain elevated. See chart below.

It is evident that Q1 2016 earnings are expected to be horrible. Just in the last two weeks, Q1 estimates have dropped from -7.6% to -8.3% while the market has rallied. The amazing thing about this chart is the dramatic bounce in the second half of the year and into 2017. In Q3 2016 and Q4 2016 it expected that earnings grow 5.0% and 9.2% respectively. That will be quite the turnaround considering the -8.3% drop we are expecting in Q1. We will see if this materializes.

Conclusion

It is a complicated time to be an investor. I do my best to always keep an open mind. I continue to look for undervalued companies even though I believe the broader market is on the expensive side. In the meantime, cash is always a position. I am certainly not as bearish as many others. I think there are a lot of people out there looking for the next “big short” and the bears love to make noise. I’d rather make my own assumptions, stay patient, and wait for my pitch.